Reforming the rating agencies

Restoring their credibility is crucial in order to make the world a fairer and flatter place

Emerging market and developing economies (EMDEs) are meted out unfair treatment by the credit rating agencies. India is no exception.

A UN paper shows that the sovereign credit ratings assignments are influenced both by hard economic data and subjective judgements, resulting in a bias in favour of the advanced economies. The EMDEs perennially receive ratings below what ought to be dictated by their economic performance and resilience.  

The paper attributes the bias to the location and origin of the staff of the credit rating agencies. The headquarters of credit rating agencies are located in the US. This itself contributes to the bias in favour of the US. Besides, they fear being legally sued by advanced economies for granting them ratings lower than what they think they deserve. A majority of the managers and analysts in the rating agencies have been trained at universities based in advanced economies, resulting in “group think” and “home bias”. Finally, given the oligopoly in the rating industry, the raters mimic one another, perpetuating the bias.

A recent example of the purported bias can be seen in the changes in ratings following the Covid-19 pandemic, wherein different countries faced economic challenges of differing intensities. Growth was more adversely impacted and the public debt accumulation was larger in the advanced economies during the pandemic. Yet the rating downgrades were more frequent and steeper in the emerging market countries.

Our own analysis of the credit ratings of the G20 countries confirms this bias. We compute the average numerical ratings of the three largest credit rating agencies, viz., Moody’s, S&P Global, and Fitch, on a scale of 1 to 20. While the average rating of an advanced economy is almost a perfect 19, that of an emerging market is 7.5 points lower, at close to a junk grade of 11.6 (the junk grade is accorded to a rating of 11 and below). The differential is not explained by the levels of growth rate, debt or fiscal deficit of these countries. The emerging countries live under the perennial threat of a potential downgrade to below the junk grade.

India’s average rating in 2022 was 12, just one notch above the speculative grade. Its rating was last upgraded during the period 2004-2007, when different agencies elevated it from the speculative to the lowest investment grade. The last two rating actions were taken by Moody’s, which first upgraded India’s rating one notch in 2017, and then downgraded it back in 2020, to the pre-2017 level.

This almost junk rating has been attributed to India despite its tremendous economic progress over the last 15 years. The size of the economy in US dollar has quadrupled and the per capita income has tripled since 2005. Inflation has declined and stabilised during the last decade; its current account deficit has hovered at sustainable levels of 1-2 per cent of gross domestic product; it has implemented a credible monetary policy framework; enhanced the independence of the central bank; made public finances more transparent; and significantly improved the quality of public expenditure.

Most importantly, it has no prior history of delaying its debt servicing obligations or debt repayments, let alone reneging on them.

India’s public debt level has admittedly been higher compared to other emerging countries. However, since the debt is long-term and denominated in the rupee, the concomitant rollover or exchange rate risks are perceived to be rather low.

It would be worthwhile for India to engage with the credit rating agencies to better understand their metrics; while reinstating its public debt on the pre-Covid consolidation trend; in order to make even a stronger case for a rating upgrade. 

The issue is pertinent for discussions at international forums such as G20 too. The G20 could help by establishing a committee to identify best practices for risk weighting and regulation at the national level. It can encourage more systematic and regular dialogue between rating agencies and government officials. The ratings are only as good as the data used as inputs for it, and data on the external debt figures of governments (and their compositions) are notoriously inadequate. It would be useful to pursue greater accuracy and transparency of debt statistics. 

It is about time that the rating agencies are asked to improve their credibility by becoming more objective in the assignment of ratings. Competition in most cases improves accountability and performance. It might be useful to support the establishment of credit rating agencies which specifically specialise in rating emerging market economies.

Reforming the rating agencies seems like a low-hanging fruit in order to make the world a fairer and flatter place.

The writer is the director general of NCAER, and a member of the Economic Advisory Council to the Prime Minister